Top trends in middle-market

private equity
About the author
Contents
Harris Smith
Managing Partner, Private Equity and Strategic Relationships 1 Executive summary

Harris Smith is a Certified Public Accountant and the managing 3 The impact of the credit crunch
partner of Private Equity and Strategic Relationships for
Grant Thornton LLP. In 1976 Smith started his career in the 7 The explosion of cross-border M&A activity
Baltimore office of Grant Thornton. In 1986, he was promoted to
partner and in 1989 he relocated to the Southern California office 11 The proliferation of operational partners
to head up the Assurance practice. In 1998, Smith was promoted
to office managing partner of the Greater Bay Area offices, and in 13 The emergence of sovereign wealth funds
2003 he became the West Region managing partner. In 2008 he
became the managing partner of Private Equity and Strategic 16 The middle-market compensation squeeze
Relationships.
18 Three hot sectors for investment
In his current role, Smith is responsible for the development and
enhancement of strategic relationships for the firm and at the 21 The natural evolution of the private equity firm
same time, overseeing the services provided to private equity
clients. This dual role provides Smith the opportunity to further 23 Conclusion
elevate the firm’s reputation and to create relationships with key
influencers to deal with challenges in the marketplace and to
enhance our brand. With over 30 years of experience, Smith is a
member of the firm’s National Leadership Team and the sponsor of
Grant Thornton’s Women’s Initiative.

Smith is a director, executive committee member and chairman of

the Association of Corporate Growth. He served as president
(2003) and director of the San Francisco Chapter of the
Association of Corporate Growth beginning in 2000. Smith resides
in Los Angeles with Jill, his wife of 26 years, and is the father of
twins, Stephanie and Jordan, who are seniors at the University of
Southern California and UC Berkeley, respectively.

Acknowledgements
The author would like to thank Danielle Fugazy, Lora DeSanto,
Pat Fanelli and Bill Haynes for their contributions to this project.
Executive summary
This white paper explores seven trends
that have recently altered the way the
private equity community conducts
business. Some of the issues explored in
the white paper are important because of
the cyclicality of the private equity
business, while others are emerging
trends that may become mainstream in
the coming years. As these private equity
trends have gained visibility and affected
investment opportunity in the middle-
market private equity sector,
Grant Thornton decided to seek a broad
perspective on their current and emerging
impact, how they developed, what is
driving them, how widespread they have
become, how they affect market
participants and what challenges they
create for the middle market.
To explore these questions, a
Grant Thornton team considered many
data points, including reviewing
Association for Corporate Growth
(ACG) and Thomson Reuters surveys,
interviewing private equity professionals
about the state of the market, and drawing
upon the expertise and experiences of our
private equity service professionals.
Through many different sources and
original reporting, Grant Thornton
compiled the white paper to give readers a
better understanding of where the middle
market is today, how it got there and
where it is heading.
The middle market has been able to hold its own quite well
compared to the big-deal market.
The key areas explored are:
• the impact of the credit crunch,
• the explosion of cross-border M&A
activity,
• the proliferation of operational
partners,
• the emergence of sovereign wealth
funds,
• the middle-market compensation
squeeze,
• three hot sectors for investment, and
• the natural evolution of the private
equity firm.
The current environment
The private equity market will finish out a
year that will be remembered as the one
when the record dealmaking streak ended.
A new era of quiet uncertainty has come
over the industry. Gone are the days of
frenzied dealmaking. 2007 produced the
third and last year of consecutive record-
breaking deal volume. According to
Thomson Reuters, U.S. buyout firms
completed only about $55 billion worth
of deals during the first half of 2008,
making it extremely doubtful that 2008
will reach the $475 billion in deals
completed in 2007.
The first trend is that a cyclical
market brings change and change
breeds uncertainty. The subprime
mortgage/housing debacle and its impact
on credit is the primary trend that has
triggered the 2008 down cycle. Private
equity firms are returning to the days
where they spend substantially more time
looking for quality companies to invest in,
and they are performing more thorough
due diligence rather than jumping in to an
investment headfirst.
However, contrary to the headlines
that grace industry trade publications, all
is not doom and gloom. The middle
market has been able to hold its own quite
well compared to the big-deal market.
That being said, there’s no denying that
there has been a flight to quality, a
contraction in leverage multiples and a
tightening of financing terms. The good
news is that deals are still getting done.
The second trend is that private equity
firms have adapted to the changing
market by opting to do cross-border
deals. Middle-market investment banking
firms, like Harris Williams & Co. for
example, say that they expect to spend
more time on globalization and emerging
markets, and they see their clients also
doing so in the next year.
Top trends in middle-market private equity 1

A third trend is the hiring of
operational partners, representing
another way private equity firms have
been able to transform themselves. Hiring
operational partners is a recent
phenomenon. While larger firms always
put big-name advisors on their letterhead,
middle-market firms have increasingly
been hiring partners who don’t
necessarily have private equity
knowledge, but who do possess expert
knowledge in a particular sector. Touting
operational partners is a good way for
firms to woo management teams in
today’s market, where competition for
quality deals is more fierce than ever.
Bringing extra capabilities to the
bargaining table can only help firms
become more competitive.
2 Top trends in middle-market private equity
With the lines blurring between private equity firms,
hedge funds, lenders and bankers, private equity firms
are emerging as asset managers.
The fourth trend affecting the private Lastly, with the lines blurring
equity community is the emergence of between private equity firms, hedge
sovereign wealth funds (SWFs). Morgan funds, lenders and bankers, private equity
Stanley researchers say SWFs, mainly in firms are emerging as asset managers.
Asia and the Middle East, poured around This trend has already begun to take
$45 billion into a range of companies and place in the larger market, and is now
assets in 2007 alone. Some analysts believe emerging in the middle market. Many
SWF assets could reach $15 trillion by believe it is the natural evolution of the
2015. SWFs are here to stay; they will industry. This white paper explores what
have an increasing long-term impact on firms are doing to drive this trend, and
the marketplace. what some middle-market private equity
The squeeze on middle-market managers think of it.
compensation is the fifth significant trend.
As the megafunds have grown even larger,
they have hired more talent to broaden
their scope, luring private equity talent
away from middle-market firms. This
white paper discusses practices that
middle-market firms are using to retain
top talent.
The sixth trend is that certain industry
sectors have remained particularly strong,
despite the global credit crisis. The
technology, health care and energy sectors
continue to present strong investment
opportunities and are expected to do so
for years to come.
The impact of the credit crunch

In August 2007, the credit markets began

Figure 1.1
their contraction, leaving the private All North American M&A activity*
equity market in a very different place For the years ended Dec. 31, 2001-07, and the period
Jan. 1-May 6, 2008, annualized
than it had been for the previous five
years. Gone are the days of frenzied
Deal value in billions Number of transactions
dealmaking; back are the days of caution
1,892
and careful due diligence. 1,799
For the next year or so, fewer deals in
general are expected to be completed. As 1,371

Figure 1.1 demonstrates, M&A activity 978 967 899

remains down, regardless of deal size.
587
However, M&A activity for deals larger 478

than $500 million has slowed considerably

more than smaller deals (see Figures 1.2
2001 2002 2003 2004 2005 2006 2007 2008
and 1.3). In addition, there has been a Annualized
Source: Harris Williams & Co. compiled from third-party sources
decrease in capital put into new private
equity deals. *Excludes minority stake purchases, acquisitions of remaining interest,
self-tenders and repurchases

Figure 1.2 Figure 1.3

M&A middle-market transaction activity M&A large-cap transaction activity
For the months ended Jan. 1, 2007-April 30, 2008 For the months ended Jan. 1, 2007-April 30, 2008

Deal value in billions Number of transactions Deal value in billions Number of transactions

$30 150 $300 75.0

$25 125 $250 62.5

$20 100 $200 50.0

$15 75 $150 37.5

$10 50 $100 25.0

$5 25 $50 12.5

$0 0 $0 0.0
11 7
7

7
11 7
7

07

07
07

07

07

07
07

07

07

/0
/0

/0

08

08
08

08
07

07
07

07

07

07
07

07

07

/0
/0

/0

08

08
08

08

10

12
1/

2/
3/

4/

5/

6/
7/

8/

9/

1/

2/
3/

4/
10

12
1/

2/
3/

4/

5/

6/
7/

8/

9/

1/

2/
3/

4/

Source: Harris Williams & Co. compiled from third-party sources Source: Harris Williams & Co. compiled from third-party sources

Top trends in middle-market private equity 3

 While private equity deals smaller not disclosed, but the Dealmaker
Figure 1.4 Figure 1.5
than $750 million experienced a less sharp Private equity volume Private equity volume estimates the price tag to be a bit over
decline in the number of deals than the for deals less than for deals larger than $100 million, which pales in comparison
larger-size deals market, total deal volume $750M $750M to Carlyle’s $6.3 billion Manor Care deal
is down from a year ago (see Figures 1.4 No. of Value No. of Value last year. The Authentix deal was
and 1.5). Overall in 2007, private equity deals (millions) deals (millions) completed using capital from its Carlyle
firms put $474.8 billion of capital into U.S. Growth Capital fund, while the
2000 179 $20.1 2000 13 $ 19.8
U.S. deals, marking the third straight year 2001 84 5.3 2001 5 6.2 Manor Care deal was completed using the
of record volume. For the first half of 2002 75 6.8 2002 11 21.9 firm’s main buyout fund. This would
2008, a paltry $63.2 billion of U.S. deal 2003 82 7.9 2003 8 13.5 seem to indicate that Carlyle has been
2004 110 15.9 2004 31 56.7
volume was recorded (see Figure 1.6). 2005 137 24.8 2005 29 87.5
focusing more on its growth buyout
“It’s still a good time for clean 2006 153 24.6 2006 66 349.1 practice rather than its large buyout fund
companies to sell in the middle market,” 2007 140 25.4 2007 53 289.3 for which it is more widely known.
2008 50 6.9 2008 9 13.9
says Mark Jones, a partner with River Other large private equity firms have
Associates Investments LLC. “If the Source: Thomson Reuters Source: Thomson Reuters decided to raise dedicated middle-market
companies are of real quality, the debt funds for the first time. At the beginning
sources are there. In fact, it’s a good time of the year, TPG Capital raised $1.2
for traditional debt players, as well. It’s Figure 1.6 billion to invest in middle-market
Private equity deals completed and funds
less competitive for them without all the buyouts. And in April, Silver Lake held a
raised through June 13, 2008
CLOs [collateralized loan obligations] final closing of Silver Lake Sumeru, its
and BDCs [business development 2007 2008 Billions inaugural middle-market investment fund,
companies] that private equity firms were Deals $474.8 with $1.1 billion of equity capital
using. Mezz guys [mezzanine investors] completed 63.2 commitments.
are a lot busier and getting involved in Buyout funds $292.2 “Getting out of your comfort zone is
larger transactions these days, but at very raised 133.6 a formula for disaster,” says Jay Jester, a
safe multiples. There are opportunities in Source: Thomson Reuters managing director with Audax Group.
the middle and lower ends of the market.” “A couple of the megafunds will put some
Even though middle-market firms are dollars to work on smaller deals, but
best at weathering the storm, deal Most of the decrease in activity has when the market comes back, they will
professionals are certainly feeling less come from the large market. As a result of leave. I prefer to focus on the 300 to 400
optimistic. According to the December large-market firms’ inability to access debt formidable middle-market firms that
2007 ACG/Thomson Financial survey, to complete megadeals, many of them really present competition.”
dealmaking professionals were less have moved downstream. However, not With larger competitors moving into
optimistic about the strength of the M&A all mega-firms are taking the same their turf, a flight to quality and harder-
market at the end of 2007 than they were approach. For example, The Carlyle to-come-by debt (see Figure 1.7), middle-
earlier at midyear 2007. Thirty-eight Group partnered with J.H. Whitney & market dealmakers are feeling pinched.
percent of survey respondents rightly Co., a middle-market buyout firm, to buy
expected transaction levels to drop in Dallas-based Authentix, which develops
2008. That was more than double the and delivers authentication and brand
number of respondents who in August protection devices. Financial terms were
2007 thought levels would drop at the
same time last year. To be fair, last year’s
survey was taken when dealmakers were Figure 1.7
Average leverage as a multiple of EBITDA for middle-market LBO deals
still in a hot M&A market and the drop- For the years ended Dec. 31, 2001-07 and Q1 2008
off had not yet hit, whereas the May 2008
7-year average: 4.3x 5.6x
ACG/Thomson Reuters survey was taken
4.7x 4.7x 4.5x
3.8x 4.3x
as we continue to be, arguably, in the 3.8x
3.4x
worst of it.

2001 2002 2003 2004 2005 2006 2007 2008

Total debt

Source: S&P Leveraged Loan Review

4 Top trends in middle-market private equity
 Some private equity firms have set
Figure 1.9
their sights on smaller deals, as well. In SF BDC price index two-year performance
April, Norwest Equity Partners bought As of May 30, 2008
Shock Doctor, a sports protection Millions
equipment company. The property was 200
acquired exclusively with equity provided 190
by Norwest and the management team.
180
The price tag was below what Norwest
170
usually pays for a deal, making it possible
160
to get the deal done debt free.
The type of debt available for deals has 150

also changed radically over the past year. 140

There’s been an enormous contraction in 130

the pool of debt buyers for new issuances, 120
particularly among collateralized debt and
110
loan obligations. According to Standard

07
06

8
07
7
6

06

8
7
7

/0
5/
/0
/0

/0
/0
5/

/0

4/
6/

16
/0
23
28

22
13
/1

04
& Poor’s, in the first half of 2008,

/1
/0

10

5/
2/
7/

12

2/
7/
5/

12
collateralized debt obligations (CDOs) 10
Source: Factset
fell for the first time since 2004. What’s
more, Lehman Brothers estimated there
would be only $30 billion to $35 billion in
new CLOs issued in 2008 — a 60 percent Figure 1.10
Performance of top four BDCs from January to May 2008
drop from 2007 levels.
As of April 2008, the number of U.S. Total return 1 2 1 3 5 QTD YTD
CDO managers on the league tables, (millions) month month year year year

which include CLO issuance, was small, BDCs ~500+ million market cap
with only five banks issuing deals, ALD Allied Capital -21% -17% -44% -21% 6% -10% -20%
ACAS American Capital -5% -15% -29% 10% 73% -12% -6%
according to Thomson Reuters
AINV Apollo Investment Management 2% 17% -18% 32% - 9% 4%
(see Figure 1.8). ARCC Ares Capital Corp. 1% -8% -26% -10% - -5% -15%

Source: Stifel Nicolous

BDCs appear to be out of favor. At the same time that BDCs started
Figure 1.8
Collateralized debt obligations for Q2 2008
Depressed valuations of publicly traded on a downward spiral, the Financial
BDCs, which were once a strong source Accounting Standards Board (FASB)
Name Market No. of Total of debt financing for middle-leveraged implemented the fair value accounting
share deals issuance
(billions) buyouts (LBOs), are also gone (see rule FASB 157, which requires the BDCs
Figure 1.9). to set the value of their private portfolio
Citigroup Global 38% 5 $2.3
Morgan Stanley 21% 3 1.3 By the end of May 2008, almost every companies to fair value based on public
JPMorgan Securities 21% 3 1.2 single BDC was trading below its book market data or other market comparables.
Barclays Capital 10% 1 .608 value as investors anticipated write-downs Many private firms are anticipating write-
Lehman Brothers 10% 2 .605
(see Figure 1.10), according to an index of downs as a result of the poor performance
Source: Bank Loan Report/Thomson Reuters BDCs compiled by analysts at investment of BDCs due in part to the impact of
bank Stifel Nicolaus. A depressed stock FASB 157.
price makes it difficult for BDCs to
originate new loans, drying up more
liquidity in the middle-market debt arena.

Top trends in middle-market private equity 5

 In fact, several BDCs are faced with
Figure 1.11
the prospect of running out of capital in Mezzanine funds raised 2000 through Q1 2008
the near future. For example, as of press
time, if Apollo Investment Corp. Fund raised No. of funds
(millions)
followed its historic investment pace, the
2000 $ 7,488.2 38
BDC was facing the prospect of having
2001 11,130.9 25
less-than-desired investment funds by 2002 2,636 25
March 2009, according to Stifel Nicolaus’ 2003 5,423.1 28
estimates. Meanwhile, as of press time, 2004 4,613.7 32
2005 8,958.6 42
MCG Corp. was virtually out of capital, 2006 1,7474 46
while Ares Capital Corp., operated by 2007 17,167.2 44
Ares Management, was looking at hitting 2008 18,186.8 11
its ceiling by the end of 2008. American
Source: Thomson Reuters
Capital Strategies had enough funds to
last into the beginning of 2009.
“Nearly all the BDCs are trading
below book value, and it’s much more Indeed, the trouble in the credit
difficult for them to raise capital,” says markets has turned out to be good for
Greg Mason, a senior equity analyst traditional mezzanine lenders in the
covering BDCs for Stifel Nicolaus. “The marketplace. As Figure 1.11 shows, the
BDCs would be putting the money to amount of mezzanine capital raised in the
work if they weren’t so constrained, but first half of 2008 was at $18 billion,
new capital is very expensive, which is $1 billion more than the amount of capital
forcing the BDCs to slow their debt raised in all of 2007. The percentage of
investments into private equity deals. We mezzanine going into deals has increased,
expect the BDCs to remain under this as has the equity contribution (see Figure
pressure for at least the rest of 2008 and 1.13). Reliable senior lenders are also in
into 2009.” demand these days (see Figure 1.12).
As a result of the issues BDCs are Andy Steuerman, a senior managing
facing, mezzanine debt has become more director with Golub Capital, explains,
prevalent. “Mezzanine partners that have “We have been very active on the senior
proven out their willingness and side because we continue to raise more
partnership mindset are at a premium capital and we have stuck by our
seeing an uptick because of that. There’s
also been a resurgence of mezz in the
market. But you can’t get the mezz
without the senior debt first.”
The last result of the credit crunch we
will discuss is that it has given strategic
buyers a chance to get back in the game.
According to Harris Williams, strategic
buyers remain aggressive for quality
assets. The firm has seen a significant
increase in strategic buyer interest in
recent months. The firm, which has
historically sold about 50 to 60 percent of
its client companies to strategic buyers,
has sold more than 70 percent of its client
companies to strategic buyers since
December 2007. “We expect to see more
activity from the strategics in coming
months,” says Hiter Harris, co-founder of
Harris Williams (see Figure 1.14).
Figure 1.14
In the next six months, what is the greatest
opportunity for liquidity events for your
portfolio companies?
Sale to
strategic
buyer 72%
Sale to
financial
buyer 22%

these days,” says Audax Group’s Jay relationships and supported the firms that IPO 3%
Jester. “People aren’t looking for the very have supported us. It’s hard to find a
Other 3%
cheapest dollar anymore.” reliable lender these days and we are

Source: ACG Thomson Survey

Figure 1.12 Figure 1.13

Average purchase price and equity contribution by sponsor Equity contribution
For the years ended Dec. 31, 2000-07, and Q1 2008 For the years ended Dec. 31, 2000-07, and Q1 2008

Senior debt Sub and other debt Equity 50%

9.3x
8.5x 8.4x 45%
8.1x
7.0x 7.2x 3.4x
6.9x 6.7x 3.4x
5.9x 3.3x 3.9x 40%
2.9x 0.5x
2.9x 2.9x 3.2x
2.5x 0.5x
0.6x 0.5x 35%
0.9x
0.9x 0.7x 0.9x
0.8x 5.4x
4.6x 4.1x 4.0x 30%
3.1x 2.6x 3.1x 2.9x 3.5x

25%
2001 2001 2002 2003 2004 2005 2006 2007 2008 2000 2001 2002 2003 2004 2005 2006 2007 Q1 2008

Source: Harris Williams & Co. compiled from third-party sources Source: Harris Williams & Co. compiled from third-party sources

6 Top trends in middle-market private equity

The explosion of cross-border activity

Figure 2.1 Figure 2.2

Office locations of the five largest private equity firms Office locations of the five largest middle-market private equity firms

● ●

● ● ● ● ● ● ●
● ●● ●● ●
● ●●● ●●● ●● ●●
●
● ● ● ● ● ● ● ● ● ● ● ●
● ● ●
● ●
● ● ● ● ●

● ●

●
Firms represented Firms represented ●
The Carlyle Group TA Associates
Warburg Pincus Sun Capital Partners
The Blackstone Group American Capital Strategies
KKR Advent International
Bain Capital Riverside & Co.

Cross-border M&A has become an Going global is not new. Large-market

increasingly vital part of strategic plans for
middle-market companies and private
equity firms. Large U.S.-based private
equity firms have already proven that
doing business in different parts of the
world often equates to success in today’s
rapidly growing global economy. Reasons
to go global include the need for
geographic diversification, the availability
of good acquisition candidates in places
outside the United States, the need to
outsource divisions of portfolio
companies to places where there are
cheaper labor costs, and the continued
consumer growth in emerging markets.
U.S.-based private equity firms started
opening up offices overseas to pursue
opportunities in the late 1990s. Today, the
five largest private equity firms cover the
world with offices (see Figures 2.1). U.S.
middle-market firms have taken this cue
and have also started expanding globally
(see Figure 2.2).
Cross-border M&A has become an increasingly vital part
of strategic plans for middle-market companies and private
equity firms.
Top trends in middle-market private equity 7
Figure 2.3 Figure 2.4
Cross-border M&A volume Private equity deals completed and funds
raised through June 13, 2008
Rank value in millions Percent of global
2007 2008 Billions
$1,500 50%

45% Deals $474.8

$1,200 completed 63.2
40%
$900
35% Buyout funds $292.2
raised 133.6
$600
30%
Source: Buyouts
$300 25%

$0 20%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007*

*Ending June 30, 2008

Source: Thomson Reuters

Figure 2.3 illustrates the proliferation

Figure 2.5 Figure 2.6
of cross-border M&A activity over the Where do you expect most cross-border Private equity volume by U.S. firms outside
past 10 years. There has certainly been a activities to take place? of the United States
decline in U.S. private equity deal flow
Western Europe 59% Value ($ billions) No of deals
(see Figure 2.4) making overseas activity
Canada 38%
more attractive. According to the May 2000 $ 27 240
China 28% 2001 21 150
2008 ACG/Thomson Reuters survey, 28
2002 29 126
percent of middle-market firms say their United States 25%
2003 45 185
firms participated in a cross-border deal in Latin America 20% 2004 61 255
the first half of 2008, and more than 55 2005 78 288
India 19%
2006 131 362
percent of respondents say their firm is 2007 194 486
Eastern Europe 16%
likely to complete a cross-border deal in
Middle East/Africa 11% Source: Thomson Reuters
the next six months. Additionally, more
Other 25%
than 40 percent of respondents say that
cross-border deals will become Source: ACG Thomson Survey

increasingly more important to their firms

over the next few years; 20 percent of
respondents believe the best way to
weather the current environment in the
United States is to diversify
geographically. Figure 2.5 shows where
middle-market private equity firms
believe they will be active in the next six
months.
What’s more, private equity deal
volume by U.S. firms outside the country
reached $194 billion in 2007, the highest
ever, and that trend is expected to
continue (see Figure 2.6).
“There’s still a market for any kind of
company anywhere, but the private
equity firms that have the foresight to go
to areas where there is higher growth and
mitigated risk will do well,” says Michael
Gibbons, a senior managing director at
Brown, Gibbons, Lang & Co. “A great
number of firms are doing cross-border
deals. We recently did a deal in Hungary
for The Riverside Co. and one in
Germany for Sun Capital. We will
continue to see this type of activity.”

8 Top trends in middle-market private equity

 Figure 2.7 lists select activity by U.S.
Figure 2.7
private equity firms overseas since the Select list of U.S. private equity firms that have participated in cross-border activity since the
beginning of 2008. beginning of 2008
The list — small, but telling —
Firm Funds raised Office opening
suggests that firms are rushing to get
overseas. However, the two areas in which Acon Investments Mexico and Brazil
U.S.-based firms have the most interest
Bear Stearns Cos. and Chinese bank Citic $1 billion Asian joint venture
are China and India. Developing
Securities Co.
countries, particularly the BRIC countries
(Brazil, Russia, India and China), present Brysam Global Partners new private equity firm
unique opportunities to access growing
Englefield Capital €1.06 billion
new markets. Although Asian investment
was once considered principally a means Arsenal Capital Shanghai
of enhancing manufacturing potential for
Sun Capital Partners $6 billion fund Tokyo
products destined for Western markets,
the vast markets that these economies JPMorgan Stockholm, Sweden
represent cannot be ignored. Although
H.I.G. Capital London
China is geographically smaller than the
United States, its population is three to Morgan Stanley $1.5 billion Asia
four times greater: about 1.3 billion.
Imagine a potential middle-class Global Infrastructure Partners Hong Kong

consumer market equal to the entire Baird Private Equity China

population of the United States, and you
can easily see why investors view China Morgan Stanley India

and other Asian countries as a market

opportunity rather than simply a place for
low-cost manufacturing (see Figure 2.8).
The same can be said for India and other
developing countries.
“There has been a lot of buzz around
India and China for several years,” says
Dennis White, a corporate partner in the
Boston office of McDermott Will &
Emery LLP and vice-chairman of ACG.
“People are very interested in those
regions, and things are starting to happen.
But there’s still a larger volume of cross-
border activity in the UK, Europe and
Canada.” McDermott Will & Emery
recently initiated an alliance with MWE
China Law in Shanghai to meet the needs
of their clients. “Everyone is looking for
opportunities anywhere they can find
Summit Partners €1 billion European private equity fund
Sun European Partners Paris and Frankfurt
Note: As of press time, not all firms raised a dedicated fund in conjunction with opening an office overseas.
Source: Grant Thornton Research
Competition for good acquisition Figure 2.8
targets in the United States has been fierce What are the reasons for going to China?
and has become even more so in the new
Produce or source goods or services in China
environment. Competition has led to for the China market 51%
more firms looking at cross-border deals;
Produce or source
having an actual footprint abroad is goods or
something most firms believe is services in
China for the
important. U.S. market
16%

them,” says White. Produce or

source
goods or
services in
China for other
(non-U.S./non-China
markets) 8%

Import into China 19%

Other 6%

Source: 2008 AmCham Business Climate Survey

Top trends in middle-market private equity 9

Best practices To support all the cross-border Figure 2.10
“There’s an invaluable benefit of having a activity and globalization, many service Private equity deal volume by all
local presence,” says Steve Collins, a providers have also opened offices around private equity firms outside U.S.
managing director with Advent the world. Lincoln International opened
Value Deals
International. “It’s hard enough to get a eight new offices recently: five in Europe, (billions)
deal done in a country where you know the latest in Madrid. Meanwhile,
2000 $ 60 1,347
the local customs and laws — forget about Houlihan Lokey opened a Tokyo office. 2001 61 1,058
a foreign country. Not all markets need a Proskauer Rose opened an office in 2002 68 859
local presence, but most do.” Brazil, and Simpson Thacher moved into 2003 101 1,165
2004 145 1,506
White agrees. “It’s easier to do deals in Beijing. Heller Ehrman LLP opened in 2005 204 2,020
the UK than in China,” he says. “There London — its first European office and its 2006 356 2,515
are varying degrees of a presence needed. fourth outside of the United States. 2007 408 3,082
2008* 71 791
Having a presence on the ground and Kirkland & Ellis LLP opened an office in
relationships with local banks and firms Hong Kong and Grant Thornton has a *Ending April 2008
can make all the difference. The customs presence in more than 100 countries: 60 of Source: Thomson Reuters
and cultural issues can make a big these member firms have experienced
difference in getting a deal done.” local M&A professionals serving clients.
Figure 2.11
The opportunity available in Still, the pendulum swings in both
Non-U.S. based private equity
developing regions is not just for U.S. directions. While there has certainly been fundraising
private equity firms. In the past year, a push for U.S-based private equity firms
many European-based firms have also to move overseas, many private equity Fund raised Deals
(billions)
moved into the growing territories. firms located outside the United States
2000 $26 101
Figure 2.9 lists non-U.S. firms that have decided to move in to take advantage
2001 25 89
recently have opened offices in of the weak dollar. Cinven, BC Partners, 2002 17 76
different regions. CVC Capital Partners, Permira and 3i 2003 27 76
2004 23 91
Group all opened offices in New York
2005 66 105
during the past few years. The presence of 2006 91 133
these new offices underscores a deal trend 2007 75 118
Figure 2.9 that has been growing for at least five 2008* 22 34
Select list of non-U.S. firms that have opened
years: European private equity firms are *Ending April 2008
offices abroad
hungry for North American targets. For
Source: Thomson Reuters
Firm Office opening/ example, in 2003, European private equity
country of deal
firms paid $622.7 million for a total of
Adveq Beijing 23 U.S.-based companies, according to Impact
Champ Private Equity Singapore Thomson Financial. Last year, that Private equity firms and companies that
Istithmar Shanghai
Candover Hong Kong number grew to $27.7 billion for 63 U.S. support the private equity industry are
Bridgepoint Poland targets. expected to continue opening offices all
FountainVest China “With the depressed U.S. dollar, it over the world. Most private equity firms
Ontario Teachers’ Pension Plan London
makes sense for firms to have interest in will wind up being global to some degree.
Source: Grant Thornton Research U.S. targets,” says McDermott Will & “The private equity industry is centered in
Emery’s Dennis White (see Figures 2.10 the U.S. and grew up in the U.S., but
and 2.11). taking it beyond the U.S. is a natural
extension of the industry,” says Advent
International’s Steve Collins. “There may
be a slowdown in the near term, but
directionally, cross-border activity will
continue to grow.”

10 Top trends in middle-market private equity

The proliferation of operational
partners
Twenty-two percent of respondents to the
May 2008 ACG/Thomson Reuters survey
cite strategic investors as one of the
greatest impediments to dealmaking
today. Increased competition from
strategics, coupled with the proliferation
of private equity firms, have made wooing
management teams into a sale more
challenging than ever, especially for teams
that plan on participating after the
buyout. Over the past couple of years, it
has become more common for private
equity firms to hire operational partners
in hopes of gaining a competitive edge.
According to the ACG/Thomson Reuters
survey, about 80 percent of respondents
believe there has been an increase in the
number of private equity firms hiring
operational partners. While these partners
are not hired for their expertise with
private equity, firms expect them to have
expansive knowledge of the sector they
worked in and be able to deliver added
value to their portfolio companies.
When Lincolnshire Management
decided to hire James Binch as a senior
operating partner and managing director,
the New York-based firm was looking for
someone who was a capable fixer of
companies. After being a seller in the
marketplace until mid-2008, Lincolnshire
decided it was time to become a buyer
again; and having someone to help
improve the performance of portfolio
companies made perfect sense. Prior to
joining Lincolnshire, Binch was president
and CEO of medical component
manufacturer Memry Corporation
(AMEX: MRY). “What better person to
hire than someone who has on-the-
ground experience,” says Bill Buttrick,
communications director at Lincolnshire.
“It’s not primarily the sector experience
we’re interested in. Rather, we look for a
manager who is capable of getting on the
ground and figuring out what’s going on
at a portfolio company quickly.”
Lincolnshire is just one such firm that
has hired an operating partner lately. See
Figure 3.0 for recent examples of other
firms that have hired operating partners.
Many dealmakers believe
that an operating partner
gives them the edge.
From the largest private equity shops
like Bain Capital to the mid-market ones
like Industrial Growth Partners, firms are
increasingly finding operations people
invaluable to their teams.
“A lot of firms are adapting an
operating partner model,” says Brian
Korb, partner with Glocap, a private
equity recruitment firm. “And not
surprising, we have definitely seen an
increase in the hiring of these types of
individuals. These partners come with
additional credibility and a network that
can add value in a number of ways. They
can help with deal flow, apply best
practices across portfolio operations and,
when necessary, they can even parachute
in and run them.”
Another reason for the proliferation
of operational partners is the need for
private equity firms to really showcase
their capabilities to sellers, especially in
this environment. Many dealmakers
believe that an operating partner gives
them the edge (see Figures 3.1 and 3.2).
“No matter how good an idea a
private equity professional has, the
management team looks at a 40-year
veteran’s ideas differently because they
have sat in the same chair,” says Tim
DeVries, managing general partner at
Norwest Equity Partners.
Top trends in middle-market private equity 11
Figure 3.1
Select list of U.S. operating partners hired from January to June 2008

Private equity firm New hire Previous position Private equity focus

Advent International Pam Patsley First Data Corp. Financial services operating partners
Arcapita William Miller Boston Consulting Group Strategic performance
Arsenal Capital Partners Larry Resnick M&A Executive, Triumph Group Aerospace and defense
Arsenal Capital Partners Anthony Giorgio Corporate Development, SYMYX Technology Specialty chemical and materials
Blue Point Capital Thomas Cresante CEO Special Devices
Blue Wolf Capital Van Walbridge CEO of Mobile Tool International
Blue Wolf Capital Walter Stasik CEO of Genesis Worldwide II
Calera Capital Paul Walsh EFund Corp. Business and financial services
Calera Capital Clyde Thomas eFunds Corp. Business and financial services
Calera Capital (Fremont Partners) Michael Murray Head of I-bank with Bank of America
CCMP Capital John Bowlin Kraft Foods Consumer investments
CCMP Capital Denny Shelton CEO of Triad Hospitals Health care investments
DLJ Merchant Banking Neal Pomroy MD with Mercer Management Head of portfolio strategy
Doughty Hanson & Co. Adam Black Associate Director KMPG Oversee sustainability matters
Fidelity Equity Partners Gray Hall CEO of CeriCenter Inc.
Genstar Capital Paul Clark CEO of ICOS Corp. Biotech investments
Morgan Stanley James Howland President of Dun & Bradstreet
Natural Gas Partners Jack Holmes Syntroleum Corp. Deal generation
Navigation Capital Partners O.G. Greene CEO of Burroughs Corp., National Data Corp.
Norwest Equity Partners Jeffrey Greiner Founder of Wessels, Arnold & Henderson Technology add-ons
Pegasus Capital Advisors Steven Marton President of office products at Newell Rubbermaid
Providence Equity Partners Barry Allen VP of operations at Qwest Communications
Water Street Healthcare Partners Curt Selquist Johnson & Johnson
Welsh Carson Anderson & Stowe Stephen Larned Chief Marketing Officer DigitalGlobe
Welsh Carson Anderson & Stowe Daniel Lieber CEO of Union Site Management
WL Ross & Co. John Kanas CEO of North Fork Bank Distressed financial services opportunities

Source: Grant Thornton Research

necessary. And it helps to have an Impact

Figure 3.2
operational partner when you are trying Private equity firms will continue to hire
Does having operational partners give
private equity firms an edge when looking for to buy a company. When there’s someone MBA students and investment bankers,
investments? from your group who can prove they but they will increasingly seek out
have experience, management teams veteran operational partners. They will
Yes, it
demonstrates appreciate that, and it adds to the chances continue to hire any professionals who
knowledge may make them more competitive, even if
of working with them.”
and
experience Additionally, operational partners can it’s outside of what was once considered
in certain
cut to the chase, getting a job done the normal realm.
markets
79% quicker and with less trouble. “Firms “If an operational partner can make a
No, it
realize that to stay competitive in this 5 percent to 10 percent impact on one of
doesn’t really current environment, they need to extract our businesses, that puts us at a huge
make a
difference 21%
maximum value from their investments. advantage,” says Norwest’s Tim DeVries.
They can hire outside consultants, but it “Private equity has matured
Source: ACG Thomson Survey pays off to have tactical in-house advisors tremendously, and we all have to do a
you can also turn to,” says Glocap’s Brian better job. Every increment helps. Some
Lincolnshire’s Bill Buttrick explains, Korb. “You can justify paying someone operational partners help us with contacts
“It makes sense to have an operational $1 million a year if they are saving you or give CEOs advice or set a great team in
partner. A private equity company may $10 million.” place. All of those things help us perform
own 15 portfolio companies and half may superiorly.”
run into the occasional trouble. You want
the ability to air-drop someone in who
can work with current management or in
a worst case scenario, replace them if

12 Top trends in middle-market private equity

The emergence of sovereign
wealth funds
At the beginning of the year, sovereign
wealth funds (SWFs) became one of the
most talked-about new trends in private
equity. First, as this asset pool continues to
expand in size and importance, so does its
potential impact on various markets,
including private equity. Second, critics are
concerned that investments by SWFs will
raise national security concerns, because an
unspoken purpose of the investment could
be to secure control of strategically
important entities for political rather than
financial gain. However, regardless of how
controversial they are, there’s no doubt
that SWFs are here to stay.
At the end of 2006, estimates of the
investments held by SWFs varied between
$1 trillion and $7 trillion U.S. dollars.
According to The Economist, market
capitalization of SWFs is about $2.5
trillion. However, the numbers are
uncertain because of the difficulty of
counting SWF holdings. The Abu Dhabi
Investment Authority, for example, is
considered the world’s largest SWF, but
experts can only guess at its size, because it
has never been publicly disclosed.
Estimates range from $500 billion to
$900 billion.
As this asset pool continues to expand in size and
importance, so does its potential impact on various
markets, including private equity.
Figure 4.1
Super Seven Sovereign Wealth Funds
SWF
The Abu Dhabi Investment Authority
The Government Pension Fund of Norway
Government of Singapore Investment Corp.
Kuwait Investment Authority
China Investment Corp.
Singapore’s Temasek Holdings
Stabilization Fund of the Russian Federation
Source: Grant Thornton Research
Figure 4.1 lists the Super Seven SWFs,
so called because all have assets over $100
billion. While these may be the largest of
the SWFs, it is important to keep in
mind there are currently more than
30 SWFs globally.
The United States is an attractive
market for SWFs because of its history
of political stability and overall
transparency. Furthermore, the financial
expertise in the country is considered
second to none, which makes SWFs
more at ease taking on risky investments
in financial services companies.
Estimated size
(billions)
$500-900
350
330
250
200
159
158
U.S. market conditions, coupled with
large sums of capital raised by SWFs, leave
no doubt that SWFs will remain active for
a long time. In 2007, Morgan Stanley
researchers said SWFs poured around
$45 billion into a range of companies and
assets. And Merrill Lynch analysts estimate
that between $3.1 trillion and $6 trillion in
new investment dollars could be pumped
into world stock markets by such funds in
the next five years. Some analysts believe
the assets could reach $15 trillion by 2015.
Top trends in middle-market private equity 13
Figure 4.2
Recent activity of SWFs in the United States
SWF
Mubadala Development Corp.
Beijing’s State Foreign Exchange Investment Co.
The Abu Dhabi Investment Authority
Singapore’s Temasek Holdings
Adu Dhabi Investment Authority
Adu Dhabi Investment Authority
Singapore’s Temasek Holdings
China Investment Corp.
China’s State Administration of Foreign Exchange
Source: Grant Thornton Research
Figure 4.2 shows recent examples of
SWFs making their way into the U.S.
economy in general and into private equity
in particular.
SWFs raise concerns
It is important to note that most of the
SWFs do not have board seats at private
equity firms, yet there is still uneasiness
about their participating in the U.S. private
equity market. Americans accept foreign
investment to a certain degree, especially if
it adds up to more jobs for Americans. For
example, no one really complains about
Toyota producing cars in the United States
or cell phone companies opening offices
and sites in the country. Additionally, it’s
awkward to complain when SWFs have
provided cash infusions to credit-troubled
U.S. banking institutions during the past
year. But the public in general has concerns
regarding foreign investors. The most
famous example of this was the 2006
uproar over the proposed purchase of
several U.S. ports by Dubai Ports World,
which wound up pulling out of the deal in
the face of public controversy.
14 Top trends in middle-market private equity
Amount committed To whom
$1.35B/7.5% stake The Carlyle Group
$3B The Blackstone Group
$7.5B Citigroup
$9.72B UBS
10% Apollo Management
5% Sony (SNE)
$4.4 with an option to buy Merrill Lynch
$5B/10% Morgan Stanley
$2.5B TPG
Despite public perception, the private
equity community largely sees SWF
investments as beneficial. Speaking at a
conference hosted by The Deal, Gary
Parr, vice chairman of Lazard, urged the
audience to think about what state U.S.
banks would be in “if sovereign wealth
funds hadn’t been there to step in last
November. It would’ve been Bear Stearns
but all over [Wall Street]. It would’ve
been chaos.”
He continued, “We shouldn’t be
prohibiting this money from coming in.
When you look at the deals they have
made, there are so many constraints on
the sovereign wealth funds that there are
many ways to do this without a new
body of law.”
While monitoring SWFs is deemed
necessary by most in the private equity
business, SWFs are believed to be fairly
harmless. “The risk isn’t as great as people
are making it out to be,” says Dan Reid,
national managing principal, Transaction
Advisory Services at Grant Thornton.
“In fact, the risks are really no different
than they are from any foreign investors.
People really need to look at these
investments on a case-by-case basis.
Believe it or not, there’s already a lot of
scrutiny being placed on these funds to
make sure everything is legitimate. If an
SWF is one of many LPs [limited partners]
in a $10 billion fund, how much control do
they really have? Perhaps not much.”
Nonetheless, the fear exists that the
SWFs are working toward political gain.
When a U.S. private equity firm buys a
large U.S. company, everyone knows it’s
for the money. The worry is that SWFs
might not be in it just for the money. Will
the Abu Dhabi Investment Authority
really act like a limited partner if a private
equity firm is trying to buy a company that
sells an alternative to oil?
Another worry is experience or lack
thereof. Just as many argued that hedge
funds didn’t have the sophistication and
sticking power of private equity firms,
some now wonder whether SWFs do.
However, that concern doesn’t realistically
seem to be the case. “These are not
unsophisticated investors,” says Reid.
“They didn’t just come into cash, and
decide to start investing it. SWFs have
hired many experienced M&A
professionals, and many of the staff have
been educated and trained in the United
States. They are making smart financial
decisions.”
 While it remains unclear what exact impact SWFs
will have on the private equity community, there’s no
doubt that they are here to stay and will be a driving force.

The early results • In June 2008, Treasury Secretary Impact

While the end result of what will happen to
SWFs investing in private equity is not yet
known, measures have already been taken:
• In early 2007, legislation was
introduced in California to bar state
pension funds from investing in
private equity firms that are partly
owned by SWFs from countries with
abusive human rights records.
Although the bill never received
support from Gov. Arnold
Schwarzenegger and was withdrawn,
the fact that such legislation was
proposed represents a red flag for
SWF investment in the United States.
• In October 2007, the Foreign
Investment and National Security
Act of 2007 (FINSA) went into
effect, broadening the president’s and
the executive branch’s ability to
control foreign investment in the
United States.
• The European Union and the Bush
administration are backing an effort
by the International Monetary Fund
to develop a voluntary code of “best
practices” for the funds.
• Peter Mandelson, the European
Union’s (EU) trade commissioner, has
spoken out against certain foreign
investment opportunities, such as
investing in defense contractors, by
sovereign nations.
Henry Paulson worked to alleviate
concerns about SWFs. He told the
audience at the U.S.-U.A.E. Business
Council in Abu Dhabi that the United
States is open to investments from
SWFs. “As we seek to open new
markets abroad, America will keep our
markets open at home to investment
from private firms and from sovereign
wealth funds,” he says. “We reject
measures that would isolate us from the
world economy.”
However, lawmakers are still
concerned about political motivations and
will fight against opening up the United
States to the funds. As of publication of
this white paper, lawmakers were already
starting to discuss the possibility of
limiting SWFs in the country.
“This will likely be a topic in
Washington for quite some time,” says
Grant Thornton’s Dan Reid.
While it remains unclear what exact
impact SWFs will have on the private
equity community, there’s no doubt that
they are here to stay and will be a driving
force. To date, SWFs have invested
primarily in very large companies or
mega-private equity firms. While the
impact on the middle market has been
negligible, that could change in the
future. Just as many large state pension
funds started investing in large private
equity firms before they decided to give
the middle market a try, the same could
happen with SWFs and middle market.
“The opportunity is significant,” says
Reid. “There’s a whole new spigot of cash
flowing into private equity. Over time
sovereign wealth funds will make more and
more direct investments but right now
they are acting as LPs. The amount of
capital they have is staggering.”

Top trends in middle-market private equity 15

The middle-market compensation
squeeze

It’s no secret that record amounts of industry leaders. The larger the fund, the
Figure 5.2
capital have poured into private equity larger the management fee, and the more Average base salary for mid-sized private equity
firms over the past five years (see Figure compensation there is to go around. funds ($750M-$2B in assets)
5.1). While small and large buyout firms The Glocap-Thomson Financial
Title Average base salary (thousands)
alike have raised capital during the past study, the “2008 Private Equity
three years, the increasing size of mega- Compensation Report,” shows the 2005 2006 2007-08
Associate $ 88 $ 93 $ 96
funds accounts for most of the private increasing discrepancy in pay between
Senior associate 122 148 156
equity capital that currently exists. The large firms and smaller firms. Everyone Vice president 162 181 186
war chests that the mega-firms have knows that smaller firms receive less in Principal 211 238 240
amassed are unprecedented. As a result, management fees, but their staffs aren’t Source: Glocap
megafunds have been able to significantly necessarily proportionately smaller.
widen the pay gap between themselves Pay increases to junior professionals are
and mid-market firms when it comes to smaller at smaller firms, both in absolute Figure 5.3
associates and senior associates, which and percentage terms (see Figures 5.2, Average bonus for mid-sized private equity
funds ($750M-$2B in assets)
some view as tomorrow’s private equity 5.3 and 5.4).
Title Average bonus (thousands)

2005 2006 2007-08

Associate $ 88 $ 98 $111
Senior associate 122 148 161
Figure 5.1 Vice president 179 223 245
U.S. buyout and mezzanine fundraising, 1996-Q2 2008 ($mil) Principal 238 265 306

Source: Glocap
Mezzanine funds Buyout funds

$300,000
Figure 5.4
250,000
Average total cash compensation for a
200,000 mid-sized fund

150,000 Title Average compensation (thousands)

100,000
2005 2006 2007-08
50,000 Associate $176 $191 $207
Senior associate 244 296 317
0
Vice president 341 404 431
96

97

98

99

00

01

02

03

04

05

06

07

08

Principal 449 503 546

19

19

19

19

20

20

20

20

20

20

20

20

20

Source: Thomson Reuters Buyouts Source: Glocap

16 Top trends in middle-market private equity

 According to the study, an associate is
defined as a pre-MBA who generally has
fewer than five years of total work
experience, including two or three years at
an investment bank. A senior associate is
defined as having an MBA and between
four and seven years of work experience.
“The larger funds with yearly
management fees of $100 million plus
have the cushion to pay up to retain and
attract top talent,” says Glocap’s Brian
Korb. “The mid-market firms feel the
squeeze of this comp inflation driven by
the megafunds.”
According to Glocap, in 2006, an
associate at a mega-firm earned an
average of $238,000 in compensation,
including base salary and bonus. That
same position paid $290,000 in 2007-08, a
22 percent year-over-year increase. In the
large firm category, an associate makes
$238,000 in 2008, equivalent to last year’s
salary and bonus at a mega-firm and a
16 percent increase from the previous
year. However, in the mid-size range, the
average associate makes $207,000 in cash
compensation, up only eight percent
from 2006. In the two smallest segments,
a newly minted associate can expect to
earn $172,000 and $157,000, respectively,
in base salary and bonus. Both represent
four percent increases from 2006 levels.
Middle-market private equity firms are going to
have to work harder to recruit and retain strong talent.
For senior associates, the good news
Figure 5.5 Figure 5.6
is that the numbers, percentage-wise, tell
Percentage of Percentage of
a somewhat better story. Salary and compensation change compensation change
bonus at the mega-firm level are up from 2006 to 2007 from 2006 to 2007
for an associate for a senior associate
nine percent to $419,000 over 2006. For
the large firms, compensation is also up Change Change
nine percent to $356,000. For mid-size
firms, a senior associate makes $317,000, Megafund 22% Megafund 9%
Large fund 16% Large fund 9%
a seven percent increase from 2006. At Mid-market 8% Mid-market 7%
small-to-mid-size firms, pay is up six Small market 4% Small market 6%
percent to $277,000. At the smallest Microfund 4% Micrcofund 5%
funds, senior associates should expect to Source: Glocap Source: Glocap
make $223,000, a five percent increase
from a year ago. However, that’s almost
half of what a senior associate would
make at a mega-firm. Impact
Advent International hired four new Middle-market private equity firms are
associates in the past year. Steve Collins, a going to have to work harder to recruit
managing director with the firm, admits it and retain strong talent.
is harder to recruit new talent. “The According to Glocap’s Brian Korb,
supply of associates is the same, but the one recruiting tool that mid-market and
demand is three- or fourfold from what it small private equity firms can use to help
was. There are big funds out there now retain quality staff is the promise of a
where increasing salaries doesn’t change faster path to becoming a partner. Some
their bottom line that much. But it isn’t as associates and senior associates might be
easy for smaller funds,” says Collins. willing to take less money with the
A mid-market private equity promise of earning much more when they
professional who wished to remain off the join the partnership, which can happen
record agreed that the competition is much more quickly at a smaller firm.
tough. “I can’t believe what kids coming Small firms also arguably give junior level
out of banking are demanding. It’s not staff a better opportunity to learn the
only the pay, but the options. It wasn’t ropes of the business.
always like this, but now they are Some private equity firms have tried
choosing between staying in the banking other tactics to retain their staff. A
industry, and going to a private equity handful, mostly unsuccessfully, have tried
firm or a hedge fund. They have more to raise management fees to produce the
options. If there used to be 100 jobs extra cash for compensation. “It’s
available to these people 10 years ago, challenging to a certain degree to stay in
I would say there are 500 now.” the middle market,” says Korb. “If your
success allows you to raise a much larger
fund and move out of the middle market,
then you run the risk of growing out of
your sweet spot. However, if you turn
down the extra capital, you risk cutting
off the additional resources to hire and
retain top investment professionals to
maintain your previous success.
It’s tricky.”
Top trends in middle-market private equity 17
Three hot sectors for investment

It’s no secret that noncyclical sectors are

Figure 6.1 Figure 6.2
the best ones to invest in right now. Sectors that will experience the most M&A M&A deal volume for energy and power deals
Grant Thornton has identified three activity through 2008
sectors that are heating up in today’s Rank date Value (millions) No. of deals
Energy 20%
environment: energy, health care and 2000 $323,516.3 2,186
Financial services 17%
technology. 2001 268,721.4 1,819
Health care/life sciences 16% 2002 177,574.0 1,810
2003 147,388.2 2,020
Energy Technology 15%
2004 263,861.4 2,298
Energy consumption in the United States Manufacturing and distribution 13% 2005 376,034.7 2,371
is projected to rise by 31 percent by 2030, 2006 557,518.3 2,774
Consumer products and services 8%
2007 616,405.3 3,259
according to U.S. Energy Department
Business services 8% 2008* 149,493.6 987
projections. Private equity firms are
Retail 1%
undoubtedly ready to take advantage of *Ending April 2008
Other 2%
the growth opportunities in the sector. Source: Thomson Reuters
According to the May 2008 Source: ACG Thomson Survey

ACG/Thomson Reuters survey, the

energy sector is expected to see more
growth than any other sector (see Figure
6.1). Additionally, since the beginning of
2008, $15 billion has been poured into the
sector, with $10 billion in private equity
funds raised for investment (see Figures
6.2 and 6.3).
“It’s a great industry to be in,” says
David Leuschen, a managing director
with Riverstone Holdings. “It’s huge,
and there’s a large food chain. The
opportunities are growing, there are more
assets to buy and there’s more volatility.”
According to Riverstone Holdings,
there are about 100,000 energy companies
globally with more than $8 trillion under
management.
Impact
All types of energy deals are seeing
activity these days, but alternative energy
is certainly garnering most of the
attention. Even Riverstone, which invests
in all types of energy companies, believes
alternative energy will grow from about
20 percent of the deals they now do per
year to as much as 40 percent, depending
on market conditions.
“We are in the process of selling a
green company on the West Coast, and it
is one of our most intense processes ever,”
says Michael Gibbons, a senior managing
director at Brown, Gibbons, Lang & Co.
“We have had 46 preliminary bids of
interest, some from private equity firms
and some from strategics and foreign
bidders, as well.”
The growth in alternative energy is
being driven by high commodity prices as
well as regulatory requirements that
didn’t exist a number of years ago.
State-by-state renewable portfolio
standard requirements in the electricity
space, ethanol blending targets in the
biofuel space, and technologies that were
completely nascent or didn’t exist
10 years ago are starting to approach
commercialization.

18 Top trends in middle-market private equity

 However, while transactions in
alternative energy can vary widely, sector
fragmentation is the single attribute that
remains constant. “You have a lot of
highly fragmented services in the energy
sector,” says Grant Thornton’s Dan Reid.
“Especially in oilfield services. This
industry was depressed for 15 years prior
to the last couple of years, and many
entrepreneurs are considering exiting or
retiring. In addition, we have seen a
significant trend that children don’t want
to take over family businesses anymore,
so these businesses will likely be sold.
This creates an incredible opportunity to
roll these companies up.”
Another factor driving energy deals is
the price of oil. As the price of a barrel of
oil continues to remain high, spending the
money to find an alternative makes
economic sense. “At $110 a barrel,
alternative energy becomes feasible and
many traditional energy companies look
attractive. There’s no question why money
is starting to focus there,” says Reid.
Health care
The health care industry has become an
especially popular destination for buyout
firms to invest in these days. The industry
is generally viewed as a recession-resistant
safe haven when times are bad. In good
times, it’s as appealing as any other
growth sector. But with the baby boomers
coming of age, the need for health care
companies continues to grow every day.
“We are seeing the aging population
accelerate faster and faster. So there will be
lots of different opportunities in this space
for the next 10 to 15 years. There will be
more and more people to be served,” says
Jeff Benton, a partner in Grant Thornton’s
Corporate Advisory and Restructuring
group. “There currently exists a
disconnect between the amount of
services available and the projected
population growth.”
Impact
Private equity firms are working hard to
fill that gap. According to Venture
Intelligence, health care private equity
firms reported 19 deals worth
$425 million in the first quarter of 2008.
Overall, M&A deal volume is still
increasing (see Figure 6.4).
Jonathan Goldstein, a managing
director with TA Associates, explains,
“A lot of firms are interested in the health
care space,” he says. “It’s considered
recession-proof. And unlike many
industries where you can have a short
product cycle, health care companies have
a longer life span. The pace of change is
not excessively rapid.”
In 2007 and the beginning of 2008,
plenty of private equity firms began
gearing up for health care investments
(see Figure 6.5).
Figure 6.4
M&A deal volume for health care targets

Rank Value No. of

date (millions) deals
Figure 6.3
Select energy funds raised from January to June 2008 2000 $148,210.8 1,308
2001 92,281.0 1,231
Firm Fund Amount 2002 103,612.2 1,200
raised 2003 99,707.7 1,536
Avista Capital Partners $2B 2004 168,265.3 1,771
2005 175,235.4 1,986
Alinda Capital Partners Shaw Infrastructure 2006 266,929.7 2,165
and The Shaw Group 2007 265,050.7 2,300
Investments 2008* 75,085.9 649
NGP Energy Capital Natural Gas Partners IX LP $4B
*Ending April 2008
Crosslink Capital $400M
Source: Thomson Reuters
TCW Group TCW Energy Fund XIV $2.6B
Energy Investors Funds United States Power Fund III $1.35B
Figure 6.5
Tenaska Capital Management Tenaska Power Fund II $1.5B Select health care funds raised January-June 2008
NGP Energy Technology NGP Energy Technology $300M
Partners Partners II LP Firm Fund Amount raised
(millions)
Cadent Energy Partners Cadent Energy Partners Ii LP $475M
Water Street Healthcare Partners Second $
600
Canaan Resources Canaan Natural Gas Fund X $250M
Signet Healthcare Partners First-time fund 200
Blue Tip Energy Partners Blue Tip Energy Partners I $160M Galen Partners Galen Partners V 250
Shefa LTD Middle East 15
Hudson Capital Hudson Clean Energy Partners $1B
New Spring Capital 150
Riverstone Holdings/ Riverstone/Carlyle Global Energy $2.4B East West Capital Partners Asia 400
Carlyle Group & Power Fund IV Flexpoint Partners 1,200
Beekan Petty O’Keefe & Co. 650
Trust Company of the West TCW Energy Fund XIV $2.6B
DW Healthcare Partners DW Healthcare Partners II 133
Goldman Sachs Goldman Sachs $520M Health Enterprise Partners Health Enterprise Partners 63
Concentrated Energy Fund Goldman Sachs Goldman Sachs Healthcare FOF 100

Source: Grant Thornton Research Source: Grant Thornton Research

Top trends in middle-market private equity 19

 Grant Thornton’s Jeff Benton has
observed this development. “People are
always going to need health care and
services,” he says. “Private equity is in a
great position to take advantage of the
growing demands.”
However, there are risks. The major
one is an increase in the reimbursement
rate, which will most likely be seen after
the 2008 U.S. presidential election. A
change in reimbursement rates will adjust
any company’s earnings, in most cases not
for the better. Another risk includes
changes to government regulation. “It’s a
solid place to invest, but there are traps
investors need to be aware of,” warns
Goldstein.
Technology
Despite the credit crunch that has
paralyzed almost every other industry,
mid-market tech buyout firms appear to
be particularly active. Many tech investors
believe they are going to see another
vintage year, reminiscent of 2000 and
2001, when tech buyouts, on a dollar
volume, accounted for 14 and 21 percent
of all transactions, respectively, according
to Thomson Reuters. Already, the
numbers are proving the tech investors
right. In the first quarter of 2008, the
$19.7 billion in closed tech deals
accounted for 31 percent of all buyout
transaction deal volume involving U.S.
sponsors. Furthermore, the growth is
expected to continue (see Figure 6.6).
Figure 6.6
Sectors that will experience the most M&A
activity through 2008
Energy
Financial services
Health care/life sciences
Technology
Manufacturing and distribution
Consumer products and services
Business services
Retail
Other
Source: ACG Thomson Survey
20 Top trends in middle-market private equity
“The tech industry is holding up better
than most industries,” says Marc Chiang,
director of the Transaction Advisory
Services group at Grant Thornton. “Clean
technology has been growing, and that is a
contributing factor. For the largest private
equity firms there still isn’t too much
activity, but the middle market and the
corporates have been active.”
The first indication that tech is in
favor is the amount of funds raised to be
invested in the sector (see Figure 6.7).
Figure 6.7
Technology funds raised
2000-08
Funds raised No. of
(millions) funds
The second factor that makes tech
2000 $26,051.6 45 strong is that competition for deals has
2001 19,031.3 35
eased, due in part to the departure of
2002 8,978.3 19
2003 3,341.1 16 generalist firms that have been scared off
2004 5,813.3 22 by the lack of credit. However, for firms
2005 6,023.7 24 that play in the tech space, the lack of
2006 25,548.3 26
2007 23,457.1 31
leverage is common; market conditions
2008* 15,400.0 9 aren’t so far off from what they were
prior to the past few years. In general,
*Ending April 2008
these companies use less leverage than
Source: Thomson Reuters
your normal buyout.
“Tech companies are made up of IT
and people, so lenders have always been
skittish about lending to the industry,”
Impact
says Nicholson. “We are used to this;
“The thing about tech is that you always
generalist funds may not be. We have
have to be thinking about the future, the
always had to look at all the ways to get
next thing,” says Chris Nicholson, a
a deal done, and sometimes it’s with
partner at Vector Capital. “Even a boring
less leverage.”
tech company needs to be looking ahead.
Also helping the tech buyout scene:
And just like in the early 2000s, now is a
Corporate orphans are easier to buy these
good time to be working on the next
days because companies are looking to
thing so companies are ready when the
shed noncore assets. Though prices have
market comes back. Now is the time to
fallen nearly as low as they did in the
20% buy: Valuations are low; you can make
aftermath of the 2001 tech wreck, now is
17% changes and be ready with a sales effort
still a good time to pick up assets.
when things pick up.”
16% Furthermore, the industry has matured,
15% making it easier for private equity firms to
13%
understand the business propositions.
Additionally, because of their maturity,
8%
these firms now have an operating history,
8%
making them easier to understand and
1%
more attractive to private equity investors
2% than ever before.
The natural evolution of the
private equity firm

While private equity’s place in the market

used to be clear, recently the lines between
private equity and other asset classes have
started to blur. Many of the large players
have diversified their offerings: buying
hedge funds, raising middle-market funds
and launching new vehicles to capitalize
on the dislocation in the credit markets.
There are a number of middle-market
Figure 7.1
Is raising a diversified set of investment funds the wave of the future for middle-market
private equity firms?
Yes, it only makes sense for private equity firms to be able to show
LPs a diverse offering 12%
Yes, the large market is already doing it, it’s just a matter of time until the
middle market follows suit 30%
No, that’s not what private equity investing is about 40%

firms that have also expanded beyond I am not crazy about the idea, but my firm may eventually have to
their normal realm. The practice allows do it to stay competitive 18%

LPs to look at private equity firms as a

one-stop shop, while giving private equity
firms the opportunity to stay active
regardless of market conditions. However,
the question remains: Can private equity
funds be all things to all investors?
According to some, just as there has
been a consolidation in the number of
companies that make cars, the same will
happen in the private equity world.
Thirty-five years ago, when private equity
was really making a name as an asset class,
companies were bought cheaply and the
new owner could make a few changes
while generating a profit and a high return
for the investor. That simply isn’t the case
anymore. Because of the increased
number of private equity firms, hedge
funds and strategic buyers, there is much
more competition, prices are up and
returns are on the decline.
“It’s natural that over time the private
equity industry will consolidate,” says
Stewart Kohl, co-CEO of The Riverside
Co. “Every other industry has, and why
Source: ACG Thomson Survey
should we be different? Based on
competitive advantage, there’s going to be
an evolution where most of the talent and
money ends up in firms having 200 or
more employees and $5 billion or more in
assets under management. However, as
private equity firms grow, there will
continue to be increasing specialization by
industry, stage, geography and other
factors. For example, even with our
multiple funds in various geographies,
Riverside will continue to dedicate itself
to the smaller end of the middle market.”
According to results from the May
2008 ACG/Thomson Reuters survey,
while middle-market firms are split on
whether diversification makes sense, most
think asset expansion is inevitable (see
Figure 7.1).
“It’s easy when you can diversify your
assets within one firm that you trust,”
says one LP. “You just have to be sure that
the firm has the proper infrastructure to
support so many different businesses.”
Jack Katz, Grant Thornton’s
New York Cluster managing partner and
Financial Services group national
managing partner says, “If a private
equity firm has the track record, it can
set up other funds to remain nimble,
especially at times like we are
experiencing. For example, more
distressed funds are being set up now,
but those private equity firms may
choose to start a different fund in the
future. There are advantages to
diversifying within the same fund.
You can choose between different
alternatives in different industries.”

Top trends in middle-market private equity 21

 Indeed, and the bottom line is that
LPs want solid investment choices. “It’s
all about generating good returns for your
investors,” says one private equity player.
“Managers don’t get in trouble for
suggesting to invest in well-established
funds with a good track record, but the
manager will get fired if the recommended
investment results in lost capital for the
LPs. Once you have the track record,
raising multiple funds is a good growth
strategy for PE [private equity] funds,
assuming that they can execute
successfully on the expanded philosophy
and don’t compromise what made them
successful in the first place.”
The trend really started recently with
the megafunds, which have built out their
businesses in many different directions.
For example, in the past year, TPG has
raised $3 billion for distressed investing,
$1.2 billion for middle-market buyout
investments, $7 billion for financial
services investments, and $4.2 billion for
investment in Asia. This is on top of an
$18 billion fund the firm raised to handle
its regular private equity investments.
TPG is not alone. While other
megafunds might not have raised as many
different types of private equity funds,
some are raising different vehicles
altogether to keep business robust, even
if regular LBO business is not. The
Blackstone Group raised several new
funds during the past year. Blackstone
raised $1.3 billion for distressed investing,
a $400 million CLO vehicle called St.
James’s Park CDO B.V., seven U.S.
CDOs with $4.7 billion, four European
CLOs with $2.9 billion, and two private
mezzanine funds with $2.1 billion. All
told, the firm’s new CLO group manages
$14 billion across 26 funds in the United
States and Europe. Additionally, in March
the firm acquired GSO Capital Partners, a
hedge fund, for $365 million. This is all in
addition to the firm’s $21.7 billion buyout
fund, not to mention its real estate and
mutual funds.
22 Top trends in middle-market private equity
Figure 7.2
Can middle-market private equity firms handle raising and putting multiple funds to work?
Yes, we might have more overhead, but it’s possible 28%
Yes, but it will take a significant ramp-up period 35%
No, it just wouldn’t add up. Returns would be diminished with all
the extra overhead 26%
No, fundraising is too exhausting -- there would be no time to put
the money to work 11%
Source: ACG Thomson Survey
It’s clear that the listing of large-
market firms raising multiple funds can go
on and on. However, right now there are
just a handful of middle-market firms
following suit. Riverside has successfully
raised a buyout fund, a microcap fund and
an Asian fund, all on top of a European
fund. Monomoy Capital Partners closed
an inaugural turnaround fund with
$280 million in capital commitments.
TriLyn LLC and Investcorp have held
$100 million for a first close on TriLyn-
Investcorp Mezzanine Partners I, a fund
that will make structured mezzanine and
other high-yielding debt and preferred
equity deals in U.S. commercial and
residential real estate. The Audax Group
also has a private equity fund, mezzanine
and senior debt funds. Sun Capital
Partners has diversified its fund offerings.
Impact
While turning into true asset managers
may be the wave of the future, it’s not
expected to happen overnight. “The
private equity industry will continue to
evolve, and it will take 10 to 20 years for
this consolidation to play out,
importantly because fund lives are long,”
says Riverside’s Stewart Kohl. “And there
will always be some private equity shops
that choose to stay small and operate as
boutiques. But most of the large pension
funds and other leading private equity
investors would really like to find homes
where they can invest larger amounts
without doing multiple searches and
monitoring multiple firms.”
According to the May 2008
ACG/Thomson Reuters survey, despite
the interest of LPs, raising multiple funds
won’t be an easy task (see Figure 7.2) for
middle-market private equity firms.
“It’s smart from a private equity
standpoint,” says River Associates’ Mark
Jones. “It broadens their depth and
exposure. And you have been seeing
middle-market funds carve out new
funds. At ACG Capital Connections, you
see a couple of different names at one
table, then you come to learn they are all a
part of the firm. But it’s a much larger task
for middle-market firms. It’s going to take
a while for middle-market firms to be able
to offer investors what Blackstone can.
The megafunds have the resources. The
middle market is approaching this much
more slowly.”
According to Grant Thornton’s Jack
Katz, the evolution has already started,
and it will just keep on going. “Private
equity has been around for a long time,”
he says. “It goes through different
variations and reinvents itself from time
to time. Firms adjust their focus, debt
ratios and fund sizes, so this is not
necessarily so surprising.”
Conclusion

It is clear that private equity has entered a
different era of dealmaking. With the
proliferation of cross-border activity,
operational partners and sovereign wealth
funds, and private equity firms becoming
all-around asset managers, the industry is
poised for more growth than ever before,
despite the credit crunch. All of these new
trends solidify two key points: Private
equity is an ever-changing and maturing
asset class, and savvy private equity
investors have proved there are ways to
reinvent the business and create new and
exciting opportunities.
Nevertheless, there are factors and
trends that suggest caution is in order. In
the next year or so, the use of SWFs will
be carefully monitored, even though most
believe the massive amounts of capital
they can introduce into the U.S. economy
would create more benefit than harm.
Additionally, the large-market private
equity players will continue to put the
squeeze on middle-market players for
talent, as well as deal flow. Until the credit
markets open up again, large-market firms
will continue to look at smaller deals,
creating more competition for mid-
market and smaller firms than ever before.
However, private equity has proved time
and time again to be cyclical, creative and
ultimately resilient. So when the markets
look the toughest, some of the best
investments are made.

Until the credit markets open up again, large-market firms

will continue to look at smaller deals, creating more
competition for mid-market and smaller firms than
ever before.

Top trends in middle-market private equity 23

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